Online Investment Advice

This Year's Model
A colleague sent me a link to a company called Betterment, which states in its home page that it is the "most trusted online financial advisor." I can't say that I shared that trust, as although I know that online advisors exist, I had not previously heard of that firm (or any other, for that matter). However, I was intrigued as I went through the website. The site is well designed, the service looks to be useful, and the price is right.

The company aims to "democratize financial advice and management" by offering "personalized, optimal advice." Aside from its investment expertise, the company promises to take into consideration investor behavior, as it blends "the best of modern finance and behavioral finance."

The service charges 0.35% of assets, annually, for the smallest accounts, which are small indeed--investors who have put $100 down with a commitment to auto-deposit at least that amount each future month. Those with a $10,000 monthly balance pay 0.25%, and those with $100,000 pay 0.15%. Clearly, the site does not compete with traditional financial advisors. It aims smaller, both in terms of customer assets and in pricing. 

Betterment is for those in the accumulation phase, not for retirees. It operates according to the bucket approach, so that each investor goal is funded by a different pot of money and has its own asset allocation. All pots are invested into the same 12 exchange-traded funds. Effectively, Betterment manages a series of funds of funds, each of which holds a different mix of the 12 ETFs depending upon the target asset allocation. They are not technically funds of funds, but they behave that way.

The ETFs are relatively cheap, mainstream offerings from Vanguard and iShares (six funds from each company). Their expenses are about 0.15% per year, on average, meaning that with Betterment's fees, the all-in cost for the service ranges from 0.50% for the smallest accounts to 0.30% for the largest accounts.

Although the funds are those of Vanguard and iShares, the presentation and resulting portfolios are very much in the spirit of Dimensional Fund Advisors. Like DFA, Betterment batters the reader with academic respectability. Its investment board contains two Ivy League finance professors; its website links to pages about Harry Markowitz, Ken French, and Gene Fama; and its portfolios are based on "decades of Nobel-prize winning research," using the "Black-Litterman expected returns model" and "optimization for downside risk measures." Betterment also emulates DFA in favoring small-company and value stocks, having high international exposure, and in overweighting emerging-markets stocks for its more aggressive portfolios.

In other words, Betterment walks and talks like DFA-light--DFA for those who can't afford a financial advisor. Its portfolios are not as heavily tilted toward smaller companies and value stocks as are DFA's, and its ETFs have different trading policies than do DFA's funds (see Tuesday's column for more on DFA's trading approach), but they will certainly behave similarly. When DFA's funds are faring relatively well, you can bet that Betterment's portfolios will do so, too.

To test the allocation advice, I created three goals, each of which was a standard option on the Advice screen. I clicked "House" and submitted that I needed $50,000 in five years' time and had $10,000 currently. I was told to invest in a portfolio of 49% stocks, 51% bonds. 

I clicked "Regular Retirement," which is a taxable account, as that option is to be used only for those who have exhausted their IRA options. I stated that I am 52 years old, wish to retire at age 68 with $500,000 in this account, and that I now have $100,000. The recommendation was 83% stocks, 17% bonds.

Finally, I clicked "Build Wealth," which is for taxable assets that have no stated purpose but may have a time horizon. I entered an initial investment of $5,000, and the default time horizon was 20 years. The recommendation was 90% stocks, 10% bonds. I modified the investment to be $1 million, was told that the maximum permitted amount is $100,000, removed a zero, and received the same recommendation of 90% stocks, 10% bonds. I returned to the starting amount of $5,000 but cut the time horizon to 10 years. Once again, 90% stocks and 10% bonds.

(The moral of the story:  If you find yourself with loose change, invest it in 90% stocks, 10% bonds.)

After giving the asset-allocation recommendation, the site graphs the goal, showing the expected growth over time of the current investment plan, expressed probabilistically as a range of potential returns rather than as a single line. Clicking on "Advanced Settings" for the House goal took me to a page that allowed for monthly contributions in addition to the stated initial amount of $10,000. Entering a monthly contribution of $200 did not change the asset-allocation recommendation, but it did change the expected-growth picture. On that screen, I could also adjust the Asset Allocation slider to see the effects of adding or subtracting stocks.

Yes, it's simple, very simple. For me, though, that's the right way to go. Fifteen years ago, I worked on the first version of Morningstar's 401(k) advice software (which is now called Morningstar Retirement Manager). We took the opposite approach, asking users many questions over many screens, so that we could build the best possible portfolio taking into consideration their unique circumstances. That was a mistake. Few had the patience to complete the process. And for those who did, the recommendations tended to be confusing, as so much information went into the decision that it was difficult to separate cause from effect.  

Also, Betterment serves those who have the simplest investment issues.

As this column noted on Monday, investing in retirement is much more complicated than investing for accumulation. In the accumulation phase, which features (mostly) fixed future goals, the timing of market returns is immaterial to any single investment (although it does matter for a string of ongoing investments, as with ongoing contributions). The market might rise early in the period, then fall, then rise again. Or vice versa. The order is unimportant, except perhaps to the investor's psychology. In retirement, timing most certainly does matter. That greatly complicates the task of asset-allocation advice. Setting asset allocations for accumulating goals is an easier endeavor.

Presumably, too, the Betterment customer does not face many of the tax issues that increasingly become intertwined with investment policy as wealth grows. Mitt Romney's 2011 tax return was 379 pages. A Betterment customer opening a $10,000 account, on the other hand, might well get away with a 1040EZ.

The behavioral-finance claim, however, doesn't overwhelm me. The main reason that investors will minimize the "performance gap" between the funds' dollar-weighted returns and their time-weighted returns (language swiped borrowed directly from Morningstar, by the way, including a "Mind the Gap" London Tube reference that Morningstar first published in 2005) is because they own a portfolio of ETFs rather than hold them individually. Fine, but professional investors, including Betterment itself, are not immune to that disease.

That's just a quibble. In all, Betterment meets an unfilled need at a good price. Whether its business will succeed is another matter. I am skeptical. Even though Betterment's site requires little effort, little effort is more effort than most investors will take. Checking a box for a target-date fund, or possibly for a 401(k) managed account, is about as far as they will go. In addition, larger and more involved investors will be tempted to free-ride Betterment's service by purchasing the underlying ETFs directly, thereby forgoing Betterment's fee.

Then again, if I were good at predicting business results, I wouldn't be a columnist, would I? (Those who can't do, write, and those who can't write, teach writing.) In this, though, I surely am not alone. I'm pretty sure that Betterment and its competitors are also uncertain about their futures. This field is a new one indeed. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.